US market takes bizarre turn as election approaches

Many investors claim they are anticipating a soft landing for the US economy, but market swings suggest they are seizing on any excuse to position against that thesis.

There is decisive and growing consensus favouring a US economic soft landing. Or rather, that’s the impression left by analysts in sell-side and buy-side notes.

But if you take your cue from markets, you’d think investors are convinced the US will tip into recession next year — except when they seem to be on high alert against a return to rising inflation.

It’s rare to see market participants betting erratically against their stated convictions. But what are the forces at work?

Just days before the vote, the US election is too close to call. That creates meaningful uncertainty, given the presidential candidates’ differing tax, trade and regulatory policy platforms.

Models suggest a one percentage point change in corporation tax adds or subtracts just under 1 per cent of S&P 500 Index earnings. So the fact that Kamala Harris would like to raise it to 28 per cent and Donald Trump would prefer to cut to 15 per cent is a binary risk for investors.

A divided government would likely soften either candidate’s fiscal plans, but Mr Trump’s broad and aggressive tariff proposals may not be constrained by Congress: they would be expected to delay the journey to 2 per cent inflation, at least, and possibly reaccelerate toward 3 per cent, with potential knock-on effects for bond and equity markets. His stance on regulation, however, is considered more market-friendly than Ms Harris’s.

Numerous electoral permutations — let alone possibility of a contested vote — are likely to  increasingly fuel volatility in coming weeks. But investors already spent much of the summer pricing as if the US Federal Reserve was falling behind the curve, inviting a recession due to its hesitancy to cut rates far or fast enough.

The broadening in equity market performance we have been talking about for much of the year hasn’t gained traction. Rallies in small caps, cyclical names and value stocks keep petering out. In rates, yields fell and curves steepened dramatically over the summer; and even after the Fed gave them a 50 basis point cut in September, futures markets responded by pricing for yet another in November.

Negotiating sharp turns

All this happened despite US inflation being above target (albeit declining), unemployment being low (albeit rising), and the economy growing at 3 per cent — a long way from zero. So, perhaps it’s no surprise that even the potential for reversal of one of those data trends was enough to trigger a sharp turn in market positioning.

When the September US payrolls report revealed a quarter of a million new jobs and a tick down in the unemployment rate, futures completely abandoned their expectations for 50 basis points in November. They took a further 25 basis points out of their pricing for 2025. The two-year yield soared at pace reminiscent of the start of the 2022 rate-hiking cycle.

Data releases sowed yet more recent confusion. When September inflation came in above expectations at the same time as (hurricane-affected) initial jobless claims spiked back to summer 2023 levels, bond prices seesawed violently. No wonder last week also saw the Merrill Lynch Option Volatility (MOVE) Index, a kind of ‘fixed-income VIX’ that tracks implied volatility of the US Treasury market, experience one of its biggest one-day jumps since the Covid-19 pandemic.

These moves are symptomatic of a market careering from hard-landing to no-landing with each new data point, without bothering to stop at soft-landing — even though it is arguably the best explanation of the data and, in many cases, the core scenario in investors’ outlooks.

These data reinforce the soft landing thesis. The mixed jobs market picture does not show the type of supply and demand mismatch precipitating significant wage inflation. Nor does it suggest universal acceleration of firing or slowdown in hiring. Instead, it depicts complexities of overlapping jobs recessions and recoveries happening across different sectors, as Claudia Sahm, the ex-Fed economist and originator of the Sahm Rule, has been arguing.

Three soft landings

Reluctance to fully embrace the soft landing assumption is understandable. It’s a difficult feat for a central bank to pull off, especially when high inflation, combined with an inflation-targeting mandate, make it risky to give a slowing economy the required monetary support.

It is generally accepted that rate hikes were followed by soft landings in 1965, 1984 and 1994. Three instances are rare enough, but in 1965 and 1994 the Fed had the advantage of relatively benign inflation. And while inflation was higher during the mid-1980s hiking cycle, so was unemployment. There was a clear need to respond with rate cuts to support growth.

It is hard to invest much faith in those historical soft-landing models today, when inflation has been high and remains above target, but unemployment is low.

To the long list of current sources of market volatility — geopolitics, the US election, the turn in the business and monetary policy cycles, crowded trades — we therefore add a strange psychological reflex that is moving prices.

Because so few are confident in their core economic scenario, each new data point is an opportunity to fuel doubts and succumb to one’s dominant fear, whether recession or inflation. In an odd mirror-image of confirmation bias, everyone wants to be convinced they are wrong.

Moderate exposure

This is why maintaining moderate exposures is not an expression of timidity, but of discipline. It is difficult to feel completely comfortable with assumptions that the Fed has perfectly navigated the narrow channel between recession and inflation. But confidence is not the same as complacency, and dispassionate assessment of economic data must admit the possibility that they can support one’s thesis.

That thesis says the US is heading for a soft landing. It makes us favour small and mid-caps, value stocks, non-tech cyclical sectors and, to a lesser extent, non-US equity markets over US large caps. It makes us cautious on government bonds, especially at longer tenors, but positive on credit, particularly less liquid markets like structured products, where spreads are less tight.

Only clear evidence that the soft landing thesis is wrong — not market dynamics alone —  will pull us away from that conviction, in either direction.

Shannon L. Saccocia, chief investment officer, private wealth, Neuberger Berman